Lords of Finance or Sorcerer’s Apprentices

The Fed meets the Bank of England

In 1927, in the context of economic weakness, Benjamin Strong the President of the New York Federal Reserve suggested to a counterpart in the Banque de France that a rate cut might give the stock market a ‘petit coup du whisky’. The subsequent rate cut set in train a fierce market rally which, boosted by margin debt, ballooned into a stock market bubble. 

According to Liaquat Ahamed’s superb book ‘Lords of Finance’ Federal Reserve officials had considered the ‘coup de whisky’ to be the Fed’s ‘greatest and boldest operation’. Yet, the collapse of this stock market bubble was one of the factors that set in motion the Great Depression.

By comparison to the actions of today’s Fed, Strong’s ‘coup de whisky’ is insignificant when compared to the huge and sustained quantities of monetary morphine that the central bank has dispensed in recent years. The near vertical rise in central bank balance sheets in the aftermath of the coronavirus crisis has suppressed market volatility, but, like morphine, it cures few underlying economic illnesses. In fact, with the echo of the Great Depression in mind, it may eventually make them worse.

With the Nasdaq index pushing through all-time highs at the start of last week (and now retreating a little), valuations becoming very stretched and an increasingly well documented retail investor trading frenzy occurring, we are entitled to ask where and when the consequences of aggressive central bank activity will lead?

While the official line at the Federal Reserve and other central banks regarding asset price bubbles is that asset bubbles are hard to identify and harder still to burst in a controlled manner, there are at least two risky side-effects of current policy, and then two potential endgames.

The first risk relates to the consequences of the ‘stupefaction’ of the political economy through monetary policy. For instance, politicians, such as the once fiscally conservative Republican party, seem to care less about rising debt and deficit levels in the face of central bank asset purchases.

In Europe, capital markets union, the consolidation and rebuilding of the banking sector, and more active and sophisticated regulation of fintech and payment systems are half made projects that lack urgency. In general, central bankers seem to focus too much on liquidity, than on the plumbing of market and banking systems.

Another side effect is inequality, in multiple forms. Wealth inequality in the US is the most pronounced since before the Great Depression. Another form is central bank inequality. The monetary aggression of the Fed and ECB makes life difficult for other smaller and less activist central banks, through the resulting fluctuations in their currencies for example. In particular in recent years, the likes of the Norges Bank and Riksbank have struggled with the side-effects of ECB policy.

Central bankers are known to be sensible, rational people and in the face of mounting evidence of the distortions of their work and the hint that they are losing their independence, we might expect them to signal an elegantly coordinated end to extraordinary policy. The opposite is likely to be the case.

The great risk to financial stability is that central bankers continue to internalize the benefits of quantitative easing, to the extent that they go into monetary warp factor and break markets. The Bank of Japan, which now owns nearly 80% of the Japanese ETF market, is a candidate here, given the store it sets by monetary activism and discussions it has conducted on monetizing government debt.

Monetizing government debt is not a free lunch, and if for argument’s sake it were executed by the Bank of Japan it could trigger broad currency volatility, a pensions crisis and a very confused credit market. Risk cannot be made to go away, it is simply distributed by markets and central banks that intervene in this process risk a ‘nuclear’ level financial accident.

The second related risk is indebtedness which before the financial crisis was – in terms of the aggregate world debt to GDP ratio – approaching levels not seen since after the Second World War, and now may be on course to reach levels comparable to the aftermath of the Napoleonic Wars. Low rates make this debt load manageable but a credit cycle downturn may result in a market unwind that even the Fed and other central banks cannot forestall. The endgame here may be a severe recession, or an broad debt restructuring conference.

Whether they are ‘Lords of Finance’ or ‘Sorcerer’s Apprentices’ today’s central bankers have contorted the financial world in an effort to stave off another Great Depression, and now having done too much, risk going full circle.

Have a great week ahead,

Mike

The Madness of Crowds

Bubble trouble

We are not yet half way through the year and, to put it mildly, quite a lot has happened. One very powerful lens with which to view 2020 so far is through the notion of crowd behavior – crowds rushing to buy toilet paper, crowds obediently dispersing into lockdown for two months and crowds in a frenzy to buy penny stocks in the US.

There is a growing literature on the behavior of crowds or how collective consciousness works, but some of the older texts are still worth a read. Gustav Le Bon’s ‘The Crowd – a study of the popular mind’ written in 1895 is one, and a much older one which I recommend is Charles MacKay’s ‘Extraordinary Popular Delusions and the Madness of Crowds’ written in 1841. It is a vivid history of asset price bubbles going back as far as the time of the Crusades, and MacKay, having published it likely hoped that people would learn from it and not repeat mistakes of the past.  

MacKay would have been alarmed though not surprised at some market behavior seen this year, an initial wave of euphoria pushing stock prices higher in February as the coronavirus crisis was unfolding, and then recent aggressive buying of bankrupt companies like Hertz and Cheasapeake Energy, and the tenfold rise in the share price of Chinese construction company FANGDD because its name resembles the FAANG acronym (its stands for Facebook, Amazon, Apple, Netflix and Google).

Since the onset of the coronavirus crisis, the number of retail brokerage accounts at onlne broker Robinhood has nearly quadrupled (there is a Robinhood Tracker app which shows what stocks are most in and out of favour with the Robinhood crowd), with other brokerage sites also seeing a rise in accounts. Apparently, half of those who open new accounts have never invested before. The only rationale for such behavior is that having bought a stock like Hertz, a ‘greater fool’ will come along to buy it at a higher price.

There is a strong sense that some stimulus cheques, and the effect of the Federal Reserve’s huge liquidity injection into markets are having the effect of encouraging reckless speculation.

If this is a cautionary tale for the Fed, its Chair Jerome Powell showed little sign of acknowledging it in his recent press conference.

With the US stock market near all time high valuations, the Fed openly risks creating an asset bubble, further deflating its own credibility and independence, not to mention spurring inefficient use of capital in the midst of a deep recession. The Fed is also guilty of reinforcing the crowd behavior or groupthink amongst central banks that blind buying of assets constitutes effective monetary policy.

If the Fed and US policymakers have enabled bad crowd behavior, what is more interesting are examples of positive collective behavior, the most remarkable of which is the way in which hundreds of millions of people have adhered to lockdown rules.

Some of the early crowd behavior during the crisis illustrates how crowds follow narratives based on short-termism and fear – such as the toilet paper mania of March – there is also a need to focus on the wisdom of crowds.  A good recent example is the way that the majority of race related protests in the US, and the reaction of the police to them, have transformed from violent to peaceful protest.

I hope that in the future more behavioural and political scientists will dig more into this area. In this respect, one theme to emerge from the crisis is the sense that ‘country resilience’ matters in coping with crises. Amongst the components of this resilience are good education systems, credible institutions, clear and fair laws and a high level of trust across society. I suspect, without having yet looked into any evidence, that high trust societies tend to produce ‘wise’ as proposed to ‘mad’ crowds.

‘Mad’ crowds do not need to be preordained. One noteworthy research project that has come to my attention recently is the work of Gary Slutkin’s Cure Violence project (cvg.org) that seeks to break down the transmission of the culture of violence through communities (and by extension ‘crowds’). Another which I have mentioned here before is the way in which social media is being used to ‘crowd think’ laws, charters and constitutions (thegovlab.org). As the desire for political change grows across many countries, crowds will be used in more productive ways.

Have a great week ahead,

Mike

The Decameron

Avoiding the Plague

Giovanni Boccaccio’s Decameron was one of the first literary masterpieces of the Renaissance. It is set in a villa outside Florence, at the height of the Bubonic Plague. Seven women and three men flee the Plague, ensconce themselves in a villa and spend ten days flirting, philosophising and debating. I have no doubt that Netflix or other entertainment channel will copy the idea and send an ensemble of Hugh Grant, Gwyneth Paltrow, George Clooney, Mara Rooney and friends off to the Hamptons to repeat the experience.

If the Decameron were to be repeated, the guests in the villa might even ponder how the world has been changed by the coronavirus. The Black Death itself radically changed Europe, largely through the demographic effect that a 30% reduction in population had – in England nearly 40% of land changed hands, a shortage of labourers meant a rise in wages and innovation of farming methods and produce.

Rising wages for those who survived the Black Death altered the social mix (Walter Scheidel’s The Great Leveler is very good here) to the extent that the wealthy begun to dress more extravagantly in order to distinguish their social standing and in this were helped by regulation (i.e. England’s Sumptuory Laws 1363).

The Black Death altered the geopolitical map of Europe (similar, much earlier plagues like the Athens Plague and Antonine Plague had profound geopolitical effects), led to trade and banking revolutions and spurred the rise of cities like Madrid and Genoa, and the demise of others like Winchester.

Back to the villa, where if our guests were discussing the post coronavirus world they might fall upon the following points. First, the coronavirus crisis has simply exacerbated the faultlines in a fracturing world – indebtedness is growing rapidly, the China-US diplomatic relationship deteriorates, and globalization is crashed.

Second, more optimistically and in the spirit of the Renaissance, the crisis will I hope bring a number of positive changes. One is the realisation of the correlation between climate damage and economic activity. Another is the sense that our cities are places to be lived in – there will be significant changes to the way cities use space, transport and commercial real estate.

A more profound change will be a trend towards improving human development – in developed and developing countries. The components of human development – from life expectancy, to education and healthcare, to economic development – have come to the fore during the coronavirus crisis in the sense that countries with high levels of human development (Germany, New Zealand, Norway) have appeared to deal relatively better with the crisis than others, and the value of good, accessible healthcare systems has become abundantly clear. I might even stretch the point to say that well educated leaders, who take science seriously, have also done reasonably well.

The concept of human development however does not lend itself to political soundbites and as such is hard for politicians to communicate as a policy goal. Neither do initiatives that promote human development pay off in the short term – so politicians need to be around to gain credit for them (Russia is an interesting example where the HDI (Human Development Indicator produced by the World Bank) has been rising steadily). Hopefully, the coronavirus will change this and permit broader discussions on the need to focus government scorecards on human development centric scorecards. If this happens, we may see public goods like accessible education and healthcare become more valued in countries like the US and UK. In this light, there is an opportunity for politicians and those involved in the policy process to craft the idea of human development in a way that people understand and value, and to put it at the centre of political manifestos.

As a final point, when I think of our ten guests in the villa in the Hamptons, Agatha Christie’s book ‘And then there were none’ passes through my head. The idea of wealthy people secluding themselves in a villa to avoid a highly contagious disease is as unpopular today as it was in the 14th century. Again, as Walter Scheidel has pointed out, the Bubonic Plague was a leveller of inequality in the 14th century though amidst plenty of periods of unrest (La Jacquerie in France in 1358 and the Peasant’s Revolt in 1381 in England).

So far, the policy response to the economic fallout from the crisis has arguably boosted wealth inequality (notably in the USA). In the coming weeks the generous provision of liquidity by the Federal Reserve will give way to rising solvency/credits risk, and with it more redundancies unfortunately. As I’ve mentioned before in these pages, market volatility will give way to social and political volatility.

Have a great week ahead,

Mike